As I have previously discussed, with the enactment of the new tax laws that took effect on January 1, 2013, most irrevocable trusts will face a higher tax liability. This is because Trusts with more than $11,950 in income in 2013 must pay the top tax rates for income, dividends and capital gains. In contrast, individual taxpayers don't trigger those rates until they report more than $400,000 in taxable income ($450,000 for joint filers). The top income-tax bracket is 39.6%, while the top rate for long-term capital gains and dividends is now 20%. In addition, Trusts pay the 3.8% Obama care surtax on basically the undistributed net investment income in excess of $11,950.
What Should a Trustee Do?
So, what should a Trustee do? Some of the recommendations you'll find online do not make any sense. I came across one advisor stating that Trusts should sell dividend paying stock and other securities (which are owned for long term appreciation) and instead consider purchasing emerging-market debt funds, REIT mutual funds and international bond funds. In a nutshell, this advice suggests that Trustees should exchange assets with a top tax marginal rate of 20% for assets with a possible net marginal tax rate of 39.6%. That advice may make sense from an investment diversification perspective, but definitely not from a tax perspective.
Another recommendation I read was to purchase insurance products or non-public offering of company shares. However, certain insurance products may result in lower income taxes, but may or may not make sense from an overall investment sense. And most Trusts do not have the option to purchase non-public offering of company shares. Even if they could, the eventual taxation is the same as would be if the Trust held publically traded securities.
The Best Advice
Probably the best advice was that savvy trustees will continue to work hard to balance capital gains and losses to reduce the net tax burden. In essence, the 3.8% surtax adds nothing conceptually, just makes the stakes higher than they were before. This advice, along with making correct tax elections and appropriate distributions, will end up with most tax efficient result.
Other good advice includes limiting a trust's tax liabilities by bunching capital gains into a given year to avoid hitting the top bracket in the next year or bunching tax deductions in every other year.
Keep In Mind
It is also important to note that the beneficiary is taxed, not the trust, when he or she gets a distribution. So, it may be possible to lower overall income taxes by paying out more to a beneficiary who's in a lower tax bracket. However, paying out principal (as one article suggested) may not necessarily lower the tax burden of the trust.
Additionally, and maybe most importantly, the words of the trust may limit the ability of the Trustee to make distributions or to limit income tax exposure. It will be important, before any significant change in distributions to be made, that the Trust is reviewed so that the Trustee is not potentially breaching his or her fiduciary duty by making a distribution. This is many times a delicate balance between the current beneficiary and the future or ultimate beneficiaries.
Finally, minimizing taxes is not always the goal of creating trusts. Many times the goal is to protect the beneficiary from himself or herself, or from others, like creditors and bad marriages, or to preserve the assets because a beneficiary has spending, medical or abuse problems. In these cases, making distributions to minimize income taxes may ultimate defeat the purpose of why the irrevocable trust was created in the first place. Now, more than ever, proper drafting, understanding the goals and objectives of clients, and creating the correct amount of flexibility in the Trust and Trustee will best serve the client.
The Bottom Line
The end result is that most Trustees must retain the services of a tax lawyer or tax accountant who understands not only trust and income taxation, but can review and advise regarding the mix of investments owned by the Trust. It is more important than ever that Trustees have the right team of investment adviser, trust tax attorney, and trust accountant!